Q: I put up a business together with my two partners this year and sales have been very good. We are expecting to hit our target profit by the end of the year. I was wondering how we are going to share the profits as dividends later when we need the cash to support the business. Can you advise? – Meg G by email
A: Dividends affect the business by way of reducing its working capital when cash is paid out to investors. A smaller working capital may mean lost income-generating opportunities from financing customers’ receivables or investment in new inventories.
On the other hand, keeping excess cash when the business is not using it may also be unhealthy. This may lead to an enlarged equity base through accumulation of excess profits, resulting to lower returns.
Paying dividends by cash reduces the equity base of the business because it is like returning a portion of the capital to the investors. This happens when there is a clear situation of excess cash and there is no better use by the business except to return it to the owners.
Declaring dividends is a financial management issue. It can be subjective and sometimes emotional. You may have a personal need for money such that you have to declare all the profits as dividends at the expense of the growth of your business. Or you may be so eager to pay out all the profits to your partners only to borrow money later to help your business survive a short-term cash flow crisis.
Distributing dividends need careful planning because it may seriously affect the future of the business. Here are the four factors that you have to consider when deciding on how much dividends to declare:
1. Availability of cash
The amount of dividends depends largely on the amount of cash available. Your company may have hit your target profit this year at Php 5 million but this doesn’t mean that you need to pay Php 5 million also in dividends. It is possible that a portion of the income that your business has earned may have been reinvested into inventory or accounts receivable. You may also have spent a portion of the profit to pay loans so that your cash balance will be less than what the business has earned.
When you have your cash balance, it does not mean that you need to distribute it all. You need to determine how much cash you need to keep in the business for working capital. This is the cash you will need to pay for salaries, electricity and other operational expenses.
You also have to forecast how much cash you need to spend for immediate expansion if any. For example, you may need additional inventories to boost your sales or additional manpower which may need extra working capital.
The amount of dividends that you can declare will be the free cash left after you have made the budget for the business.
Related: 10 tips to ensure better cash flow
2. Projected cash flows
If your business has been doing well for the first few months of your operation, there is no guarantee that this will continue for the rest of the year. If it does continue, there will always be risks that it may slow down next year. You need to project how much, more or less, cash flows you are expecting in the coming months.
If the business slows down due to unforeseen seasonal demand for your products, your cash flows will definitely be affected. You don’t want to be in the situation where you have to endure a liquidity crisis because the business was not good for a few months and you don’t have enough cash to sustain it as result of your large dividends payout.
It will be helpful if you can adjust the amount of dividends that you intend to distribute based on the expected cash flows of the business. You may need the extra cash as buffer to help your business survive any unexpected slow down.
3. Payout policy
It is always important to have a dividend policy in any business especially if it involves multiple investors. The policy helps set expectations among investors, along with how much dividends more or less should be distributed during the year, based on the earnings of the company. For example, you can agree with your investors that the payout ratio is 50 percent. If your company earns a Php 2 million profit, the minimum dividends that you can give out is Php 1 million. You can distribute this amount in four quarterly payments or two semi-annual payments to control your cash flows.
There will be times when you need to get rid of excess cash after you are done with budgeting for everything, so in this case, you can declare payout of more than the minimum of 50 percent.
4. Reasonable return on investment
If cash is a little tight and you need to distribute dividends to investors, find a way to ensure that dividends represent reasonable returns on their investment. For example, if money market funds currently offer 3 percent returns annually, make sure that the dividends paid out are much higher than the opportunity cost. You can make the effective returns to be somewhere between 6 percent and 10 percent per annum. The equivalent amount of dividends of these returns may turn out to be less than 50 percent payout.
Dividends may be based on earnings of the business but it is highly dependent on the cash flows of the business. If your business is growing and expanding, you must expect to distribute smaller dividends because you need to reinvest the cash to finance the growth of your business. When your business grows, the value of your investment also grows, and becomes far greater than the amount of dividends that you receive.
Henry Ong, CMC, is president of Business Sense Financial Advisors. Email Henry for business advice firstname.lastname@example.org or follow him on Twitter, @henryong888